We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
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Friday, December 21, 2007

I'm contacted by new bloggers a fair amount, and I honestly at least check out the sites I'm sent. Unfortunately, I don't have as much time for reading as I'd like, so the list of blogs I read regularly is quite small. But still, I appreciate the e-mails from fellow bloggers. Keep 'em coming.There is a piece on this new blog (which is trying to create a sort of independent stock research center where the reports are written by users) about iStar Financial. Fair disclosure, I'm considering a debt investment in iStar.

Anyway, toward the end of the report, the author goes into a bit about how financial stocks are in the unenviable position of proving a negative. I want to explore this idea a bit more.

No one knows how far the residential lending contagion will spread. Are banks and brokers just taking a "big bath" right now, and writedowns are near an end? Or are there one or more large financials headed for bankruptcy? What companies may have invested in sub-prime related securities, from CDOs to SIVs? Who has counter-party risk with shaky partners? What companies are so reliant on securitization that they will face a liquidity crunch? Who may need to come to the debt markets now and pay unusually wide spreads and what impact will that have on earnings?

Taking it a step further, how much will losses in home values impact consumer spending? What companies may be over-leveraged to the mortgage-equity withdrawal trend? Or consumer credit in general? What companies will be facing higher defaults from non-residential lending because easy credit has previously kept consumer loss rates low?

We are all struggling with these questions. I think I know the answer to some of these, but I must concede that my confidence level in any particular outcome is low. I think a lot of actual traders are struggling with the same problem. We know there is a lot of bad news priced into securities, but we also know there is bad news to come. And we can't be sure from where the bad news will hit.

So you take a company like iStar Financial. They are a commercial real estate lender. Now perhaps you have a "classic" reason to be bearish on iStar, such as you are bearish on commercial real estate. Fair enough. But in today's market, a legitimate concern is whether someone like iStar can weather a period where it is difficult to raise capital. And if you assume they can survive such a period, what would their earnings look like?

But there is nothing iStar can do to prove it can survive a serious credit crunch except to go ahead and survive it. Investors are in essence saying "Prove to us you won't have a problem in this environment." But no company can prove any such thing, because we don't know how much worse the credit crunch might get. Or what other types of securities or loan-types might be hit next.

A myriad of other financial stocks (and bonds) are suffering through the same thing. We know that some are particularly vulnerable. Washington Mutual, Countrywide, AMBAC, etc. But there is a large number of companies that haven't had any particular residential lending-related problem. There are other companies that have had some problems, but that there isn't any particular reason to believe there will be more. And yet because the market is asking these companies to prove a negative, the stocks (and bonds) have been beaten up pretty badly. As long as a sub-prime or contagion losses could crop up, investors are going to be highly skeptical.

One could say this is the nature of a bear market. Investors become more focused on their fears and less on their greed. Sometimes the innocent get punished. Sometimes the not-so-innocent are punished before their crime is fully revealed.

So if you are considering investment in any financial company's securities, bear this in mind. This thing is hitting all aspects of finance. On one had, we have real losses on mortgage loans. On the other hand, we have a serious liquidity crunch. On our left foot, we have much wider credit spreads. There is no such thing as a financial company for whom none of that matters. Financials, by their nature, almost always take credit risk of some kind, and need funding of some kind. There are many companies being unfairly beat up right now, but which are the innocents and which are the not-so-innocent not yet revealed is a tough call.

Even if you are right about the particular company you are looking at, the fear of the unknown will continue to dominate markets until the pace of bad news slows down. Put another way, when a company is being asked to prove a negative, there is no catalyst that will accomplish this. Investing intelligently in a market like this requires patience, stamina, and constant re-evaluation.

Posted by
Accrued Interest

9 comments:

AI : Thank you for your thoughts. I'm personally interested in the bond world for at least the next 2+ years to see how we as a world move through the upcoming Kondratieff winter that Alan the Lesser postponed (and made worse) with the rate cuts.

1) Thoughts on the link above? more specifically, is there a reason you think that analysis isn't relevant?

2) It seems rather simple to me, but that's probably why I'm not an institutional investor. Is there a fallacy in this logic:

When the US government puts on the appropriate regulations, private market credit creation will resume.. until then, we're FUBAR.

3) Other economies (EU especially) will suffer more than the US because they played the easy money game more vigorously than the US.. the 750B was to prop up multiple insolvent banks.

Do you think Bush's pressure to take the pain immediately will have an effect on bank statements?

Well, there is one institution that I cannot name (for essentially the same reasons that Voldemort can't be named) that I fear, horribly fear, is going to at some point, as far into the future as they can manage, come a cropper in this mess...and if they can, then anyone can.

The point is that fiduciary responsibility is out the window: it is "mark to model" through the looking glass.

So anyone who had a good fiduciary track record up to the present is presumed guilty with pretty good odds that they are.

I am just terrified.

And the stock market? And consumer spending? I'm in awe. I would sooner believe that statues can bleed than believe the valuations in the stock market or the lighter than air consumer spending.

The Central Bank is "Tight" -----------------------------------It may seem controversial, or you may be just confused, but the 2/27/07 market crash was Bernanke's fault. The Chinese stock market fall did not trigger other countrie's financial markets to fall.

Bernanke is smart, unlike some of his colleagues. He recognizes last year's error and he is actually overcorrecting.

Bill Gross & Paul McCulley of PIMCO views are passe'. Everyone knows about what the academics call the "Taylor Rule".

It's phony. That's what the experience we had leading up to the Treasury-Federal Reserve Accord in March 1951 was all about. The money supply can never be managed by any attempt to control the cost of credit.

Contrary to Gross, we haven't entered a recession & we are not going to experience stagflation for any extended period of time.

I'm not saying that things are rose-colored. But I am saying that 2008 will be robust.

"The Fed needs to bring Fed Funds levels down steadily and significantly more in order to counteract the contraction of the shadow banking system which has imposed, and will continue to require, higher risk premiums for non-Treasury securities in an increasingly risky financial environment." --- PIMCO Bill Gross

Bill, that's called disintermediation. The unwinding of the credit bubble (or disintermediation), will be followed by collapsing production in the private sector. And the way disintermediation is counteracted is by getting the commercial banks out of the savings business.

AI said.."So if you are considering investment in any financial company's securities, bear this in mind. This thing is hitting all aspects of finance.""

It's also hitting corporate balance sheets. Ciena (CIEN), a tech stock, reported their qtr last week and said that they lost 13 million in CP and SIV's while net income for the qtr was 30 million. Stock tanked on the news.

AI said..""So you take a company like iStar Financial. They are a commercial real estate lender. But in today's market, a legitimate concern is whether someone like iStar can weather a period where it is difficult to raise capital.""

Why take the single company risk? IMO, you are much better off buying CSP, a closed end fund (now at a discount!) that invests in commercial mortgages and has had a rock steady NAV for about 14 years with a yield comparable to a real-world, legitimate Istar yield (not the current one).

iStar has taken an interesting approach in that it funds its assets entirely in recourse unsecured debt or equity. The main advantage to this method of funding allows iStar to hold its portfolio of investments to maturity and avoid mark-to-market noise. Additionally, holding to maturity better matches income recognition to cash receipts, which is critical for any mortgage REIT. iStar's GAAP/tax differences, while growing because of ALLL, aren't nearly as distorted as that of its competitors. The most serious question is what happens when lenders begin to demand an unsustainable return due to the unsecured nature of iStar's debt. SFI's cost of funds has steadily increased, and with debt becoming less available, what happens when equity issuances become dilutive? The common is not being supported by the generous dividend yield, so how can iStar continue to afford the same rate of rapid growth?

Out of the quarterly estimates by Bloomberg of 63 economists 2 are closer to the mark (those predicting a recession in the 1st & 2nd qtrs).

Monetary flows (MVt) [Irving Fischer's equation], the proxy for inflation, it's rate-of-change, has been negative for 21 out of the last 20 months: this corresponds to Barry Ritholtz's figure of "23 consecutive month of decelerating housing returns".

The rate-of-change in the proxy for real-gdp has been negative/decelerating for 16 out of the last 21 months. It should be positive for all of 2008.

These numbers say the economy bottomed in Oct 07 this year (corresponds to Case-Shiller home price index falling 6.1% y-o-y) Then housing bottomed this month (Dec 07).

Real-gdp will rebound the first of 2008. March thru May will be WEAK/sea saw, afterwards economic activity will be robust. But everything is not rosy. Inflation is deep rooted and the probability of stagflation is high.

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.